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7. (a) Derive the Capital Market Line (CML) by using the two-fund separation theorem. Explain the concepts of the optimal risky portfolio and risk-free rate
7. (a) Derive the Capital Market Line (CML) by using the two-fund separation theorem. Explain the concepts of the optimal risky portfolio and risk-free rate of return. (9 marks) (b) An investor has $1,000,000 available for investment. Assume there are two investment opportunities available: (1) the optimal risky portfolio, with expected return of 12% and standard deviation of returns of 20%; (2) Treasury Bills (TB) paying 4%. Assume the investor can borrow or lend at the TB rate. The investor is considering two portfolios to invest in: -Portfolio A, made up of $300,000 invested in TBs and $700,000 in the optimal risky portfolio -Portfolio B, made up of -$250,000 in TBS (.e. money borrowed at the TB rate) and $1,250,000 invested in the optimal risky portfolio. Calculate the expected return and risk for portfolios A and B and draw the Capital Market Line showing the optimal risky portfolio along with portfolios A and B. (7 marks) (c) Explain how an investor would select a portfolio on the Capital Market Line. (4 marks) (d) Explain the differences and similarities between the Capital Market Line (CML) and the Security Market Line (SML)
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